EMEA dividend recapitalisations raise debtholders’ risks
The number of dividend recapitalisations (recaps) in European leveraged finance has grown this year, increasing credit risks and reducing the alignment of interests between equity investors and creditors.
A dividend recap increases leverage and erodes collateral coverage, while offering no accretive value for debt investors. Rather than using debt capacity to invest in cash flow-generating assets, dividend recap proceeds typically refinance legacy debt or add new debt while distributing additional proceeds to shareholders.
A combination of record-high enterprise valuations, low yields across the credit spectrum, and effective net deleveraging in performing sectors, together with limited secondary market opportunities and new deal supply, created conditions for a new wave of dividend recaps.
The total loan volume of recaps reached EUR25 billion in 9M21, higher than the previous record of EUR21 billion in full-year 2017, although lower in terms of the number of deals (21 and 36, respectively).
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The majority of dividend recaps this year involve companies in pandemic-resilient or beneficiary sectors, such as technology, services, consumer goods and healthcare. We expect dividend recaps to remain a feature of the European leveraged market.
However, in 2H21, they will likely reflect strong operating performance and greater flexibility to pay dividends allowed by credit documentation, rather than further improvements in credit spreads or lower leverage.
Financial sponsors use dividend recaps to improve fund performance, particularly if their other investments are subject to delayed exits. A dividend recap boosts investment returns, while maintaining an option to generate additional income from the same assets through future payments or exits.
Risk shifts from shareholders to creditors, who, during periods of high market liquidity, are compelled to roll their exposure into riskier structures or instruments.
